Question

Read the following statements : Assertion (A) and Reason (R).

Assertion (A) : The cost of debt is higher than the cost of equity for a firm.

Reason (R) : The lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital.

Choose the correct alternative from the options given below :

• A. Both Assertion (A) and Reason (R) are true and Reason (R) is the correct explanation of Assertion (A).
• B. Both Assertion (A) and Reason (R) are true, but Reason (R) is not the correct explanation of Assertion (A).
• C. Assertion (A) is true, but Reason (R) is false.
• D. Assertion (A) is false, but Reason (R) is true.

Hint:

Debt is cheaper than equity because lenders face less risk. Check whether each statement says that.

Answer 1

The Correct Option is D

Step 1: Understand the concept:
Cost of debt is the interest a firm pays on borrowed money. Cost of equity is the return that shareholders expect.
The two statements link the cost of each source to the risk faced by its supplier of funds.
We test Assertion (A) first and then Reason (R).

Step 2: Test Assertion (A):
A lender gets a fixed interest and is repaid before shareholders. Interest is also a tax deductible expense.
So debt is the cheaper source of finance. The cost of debt is lower than the cost of equity.
Assertion (A) says the opposite, so it is FALSE.

Step 3: Test Reason (R):
A lender earns an assured return and has a claim to get back the capital. A shareholder gets dividend only if there is profit and is paid last at winding up.
So the lender faces less risk than the equity shareholder. Reason (R) is TRUE.

Step 4: Choose the option:
(A) is false and (R) is true. This is option (D).
Option (A) needs both true with R explaining A. Option (B) needs both true. Option (C) needs A true and R false. None of these fits.

Final Answer:
Assertion (A) is false but Reason (R) is true, option (D).